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Negotiating management agreements during an economic downturn - some thoughts

The downturn in the global economy sparked by the credit crunch has had a significant effect on the hospitality and leisure industry both in terms of operations and development. According to STR Global’s figures for Asia Pacific, in July 2009, hotel occupancy dropped 6.3% to 61.7%, ADR dropped 15.9% to US$113.20, and RevPAR dropped 21.2% to US$69.83 compared to July 2008. We also know of a number of hotel projects that are currently on hold as developers struggle to come up with the financing required. However, “Asia showed slight signs of improvement in July, with many markets falling less than the previous month” according to the managing director of STR Global. The figures also show that the extent of the decrease in occupancy, ADR and RevPAR is less than earlier this year.

Continuing Demand for Hotel Development

Whilst the numbers are improving it is still a fragile economic situation. It would therefore be easy to assume that negotiations for management agreements in respect of new hotels have completely ground to a halt. This is, however, not true. We are aware of several major property developers and investors who remain committed to expanding their Asia Pacific hotel portfolio. Operators remain surprisingly optimistic. Some recent examples of these expanding Asia Pacific hotel portfolios include:

Jumeirah confirmed they are holding fast to plans to have 60 hotels globally by 2012.

Starwood will establish a total of more than 90 new hotels in Asia Pacific, in particular in Mainland China, Taiwan, Thailand, Japan and India, over the next 5 years.

Marriott International announced that there will be an addition of 21 hotels in the Asia Pacific region which are scheduled to open through the end of 2013. This will add 7,000 rooms to Marriott’s previouslyannounced Asia Pacific plan of 27 hotels and 9,400 rooms which are currently under construction.

Hilton announced that they expect to develop 12 new hotels in China over the next 2 years.

More recent figures reported by STR Global show that the Asia Pacific hotel development pipeline includes 997 hotels with 239,313 rooms. The Upper Upscale segment accounts for the largest portion of the active pipeline with 23.9% of rooms followed by the Upscale segment with 23.6%. We note that the Luxury segment accounts for 17.2% of rooms. Economy and Midscale without Food and Beverage segments accounts for the smallest percentage of the total active pipeline. These figures suggest a trend towards developing more Upper Upscale or Upscale hotels as opposed to Luxury or economy midscale hotels which in this economic environment might seem strange and a cause for concern that there could be over supply.

It will be interesting to see how much the mood has changed at the HICAP conference in Hong Kong in October.

How These Factors Will Shape HMA Negotiations

In summary, over the course of 2009 and into 2010: (a) property developers are likely to continue to struggle to raise capital whilst at the same time being concerned about investing in uncertain markets, and (b) hotel operators will be eager in any case to roll out their brands in Asia Pacific, particularly conscious of the lengthy lag between signing and opening. This will inevitably affect the position of owners and operators in the negotiation of hotel management agreements (“HMA”).

One likely change is that both parties will have to work hard to sculpt the HMA to attract financing. Potential hot topics and trends include:

Non-Disturbance Agreements and their terms

The need for the HMA to demonstrate a reasonable return on investment

The emergence of leases or hybrid structures as an alternative to HMAs We will consider each of these issues from an owner’s perspective and an operator’s perspective below and attempt to identify a balanced approach.

We will conclude the study by considering those owners who are not constrained by a shortage of funds.

1.THE TERMS OF A NON-DISTURBANCE AGREEMENT (“NDA”)

There has been a tendency in the past few years for operators to want a greater say in the terms of any mortgage that the owner may make over the hotel. This is most clearly seen in a shift from “Owner shall use commercially reasonable endeavours to cause the mortgagee to enter into a NDA” to “Owner shall obtain an NDA from the mortgagee”.

Owner’s perspective. Many banks are generally reluctant to lend on hotel projects at present. While an HMA may increase the value of the asset, banks would naturally prefer to exercise complete discretion over any security they hold. Accordingly, banks may either refuse to sign an NDA or increase the cost of borrowing. This may make the project less commercially viable from an owner’s perspective. The banks that we have spoken to have given a wide variety of responses, some indicating that they could be prepared to consider an NDA for the right property and brand, others indicating that they would not sign the NDA on any terms. By insisting on NDAs, operators may effectively be denying owners the right to mortgage their own hotel. Where owners secure financing from mortgagees without obtaining an NDA when required, they will be in breach of the HMA unless there are express exceptions or waivers agreed between the parties.

Operator’s perspective. The possibility of an owner defaulting on a loan has increased dramatically in the present economic environment. It is therefore natural that operators should be conscious of the need to exert a degree of control in the event of the hotel being repossessed. Operators’ primary concern is that their rights under the HMA would not be diminished either by the mortgagee or any purchaser. Without an NDA, the operator will be in a very difficult position if the owner becomes bankrupt. In recent months operators in certain cases have had to rely on NDAs for which have become distressed properties in the US.

A balanced approach? Some owners may be considered at a much greater risk of defaulting on loans than others. Of course, the last 15 months have shown that even the biggest and boldest can default. Operators may nevertheless feel that they can show greater flexibility with NDAs when dealing with well resourced, large owners than with small owners who are financially less mature. Both parties can benefit by involving any potential lenders at an early stage of the negotiation process. Nobody wants a long and tortuous negotiation to break down at the last minute because it becomes apparent that the project will not attract financing.

2.THE NEED FOR THE HMA TO DEMONSTRATE A REASONABLE RETURN ON INVESTMENT (RoI)

Some owners may sign up on a luxury brand for the kudos. However, the majority enter into an HMA with the expectation that it will produce a fair RoI. For banks, this is even more critical. There are a number of ways in which an operator may contribute towards a reduced RoI. These include:

Failing to manage the hotel in accordance with the standards promised

Insisting on capital improvements or other expenditure (perhaps in the name of maintaining brand standards) that will not lead to equivalent increases in revenue

Owner’s perspective. To ensure that they are getting a consistent and reasonable RoI, owners may want to commit operators to:

Give owners the right to control expenditure over a certain amount and not apply brand standards too rigidly

Make at least some of the fees conditional on achieving a certain RoI

Operator’s perspective. Operators are also keen to create a financially successful hotel as their own RoI depends on it. However, with a substantial base and marketing fee calculated as a percentage of gross revenue, clearly they are significantly less vulnerable than the owner when there is minimal or negative GOP. In general, owners’ and operators’ interests in running a hotel to a high standard and profitably are somewhat aligned, but the owner may prioritise the need to manage costs and preserve GOP over the need to maintain brand standards. To address owners’ concerns, operators may argue:

What makes a brand “luxury” as opposed to “upper mid-scale” is primarily subjective. While there are various lists available which rate hotels, none of them are yet considered to be “authoritative” and most, historically, have not been adapted to the Asia Pacific market

In most cases, an operator’s performance is already measured through performance tests. While these are not perfect, most alternative measures are highly subjective

Where owners are seeking to attract guests on the basis of their loyalty or respect for a articular brand, they will need to give the operator freedom to operate the hotel and use owner’s funds in order to create a hotel that will meet guests’ expectations. Operators cannot be expected to tailor their standards to each individual hotel owner’s wishes

Ultimately it is in the owner’s interest to trust and work in partnership with the operator rather than looking for ways to undermine the relationship based on ineffective and subjective measures.

A balanced approach? Banks will be very reluctant to lend to an owner where the HMA gives the operator complete freedom to spend the owner’s money. Such an arrangement would render any RoI prediction impossible, undermine the value of the hotel as a form of security and ultimately jeopardise the owner’s ability to repay the loan.

Any good faith understanding between the parties to the HMA that neither party would abuse their rights under the HMA may not be shared by the lender. A project will be much more likely to attract funding if it is clear that the owner retains the right of approval over expenditure above a certain amount. Ideally, caps should be placed on every item of expense, but it may be necessary to find a compromise. The owner will also want to retain some flexibility regarding how the operator’s brand standards are applied, particularly where they are much higher than market practice.

Banks will be less concerned about the operator’s ability to demonstrate the quality of management or the consistency of their brand standing. This will particularly be the case if it is clear from the HMA that the interests of owner and operator are genuinely aligned and there are reasonable performance tests.

3.THE EMERGENCE OF LEASES OR HYBRID STRUCTURES AS AN ALTERNATIVE TO HMAs

Banks prefer to lend to clients with a stable and predictable source of income. The income stream from a hotel is typically volatile and subject to seasonal fluctuations. In the present market, hotel owners, even if they have a very favourable HMA, may be unable to get financing on reasonable terms. One solution receiving increasing attention is the creation of a lease structure. Under this structure, instead of receiving the hotel’s profits directly, the owner gets a fixed rental income. These are more common in Europe, but in Asia it is usually only seen in Japan or where an owner is particularly risk averse (for example a government entity) or where the regulators have encouraged this in the context of structuring a hotel REIT.

Owner’s perspective. The most obvious attraction from an owner’s (and usually the lender’s) perspective is guaranteed income and a significantly reduced risk. The major disadvantage is that under a basic lease structure, the owner will get little or no upside reward no matter how successful the hotel.

Operator’s perspective. Since the early 1990’s, the direction of the hotel industry has been to separate expertise in managing and branding a hotel with the risk and expense of ownership. International and well-established operators are generally becoming “asset-light” in the past few years. Operators are wary of any structure that would dramatically increase their risk and exposure to income fluctuations. There are however some operators which see distinct advantages in a lease structure. Operators are able to benefit more fully when they improve a hotel’s profitability. Ultimately, taking a bigger share of the risk of hotel ownership may be a price operators are willing to pay to see their brands expand.

A balanced approach? A basic lease structure is likely to be a realistic option in only a limited number of circumstances and would require a flexible operator. This structure may appeal more to new operators and brands trying to expand their brand presence into new territories. It may be that a hybrid structure will prove more amenable to both parties – a hotel could for example be subject to a lease in the first few years and then revert to a more traditional management structure later on.

Owners Unconstrained by a Shortage of Funds

For some owners, obtaining financing from banks is not such a high priority. Such owners will be able to benefit from a shrinking pool of developers and the growing pool of potential operators. This increased strength may mean we begin to see some HMAs that include:

Greater flexibility regarding an owner’s right to terminate upon sale or redevelopment

More transparent fees and tighter controls on expenditure

More generous restrictive covenants

Fairer risk sharing, including indemnities from operators

More concrete commitment from operators to manage the hotel profitably and maintain brand standards.

The ability to achieve any of these will of course depend on each individual case.

Our New World Order should encourage more creative debate on how to re-position these long term contracts in a manner which equitably reflects the legitimate concerns of both owner and operator.

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